QE and Business Investment: The VAR Evidence: Part 1

A Mark Sadowski post

Mike Spence and Kevin Warsh, writing in the Wall Street Journal on Wednesday said:

 “We believe that QE [Quantitative Easing] has redirected capital from the real domestic economy to financial assets at home and abroad. In this environment, it is hard to criticize companies that choose “shareholder friendly” share buybacks over investment in a new factory. But public policy shouldn’t bias investments to paper assets over investments in the real economy.”

To which Brad DeLong responded by saying:

“As I have said before and say again, weakness in overall investment is 100% due to weakness in housing investment. Is there an argument here that QE has reduced housing investment? No. Is nonresidential fixed investment below where one would expect it to be given that the overall recovery has been disappointing and capacity utilization is not high? No. The U.S. looks to have an elevated level of exports, and depressed levels of government purchases and residential investment. Given that background, one would not be surprised that business investment is merely normal–and one would not go looking for causes of a weak economy in structural factors retarding business investment. One would say, in fact, that business investment is a relatively bright spot.”

And Paul Krugman, who said:

“It is, indeed, kind of amazing. In the eyes of critics, QE is the anti-Veg-O-Matic: it does everything bad, slicing and dicing and pureeing all good things. It’s inflationary; well, maybe not, but it undermines credibility; well, maybe not but it it causes excessive risk-taking; well, maybe not but it discourages business investment, which I think is a new one.”

And Larry Summers, who said:

“Perhaps Spence and Warsh are on to something that I am missing. I’m curious whether they can point to any peer reviewed economic research, or indeed any statistical work, that backs up their views.”

And Joseph Gagnon, who said:

“…economies in which central banks were most aggressive in conducting QE early in the recovery (the United Kingdom and the United States) have been growing more strongly than economies that were slow to adopt QE (the euro area and Japan)…. Indeed, to the extent that QE has raised stock prices, it discourages businesses from buying back stock because it makes that stock more costly to buy.”

About the only economist who rose to Spence and Warsh’s defense was Robert Waldmann, who said:

“The argument is that the duration risk in long term Treasuries is negatively correlated with the risk in fixed capital. I think this is clearly true. The risk of long term Treasuries is that future short term rates will be high. This can be because of high inflation or because the FED considers high real rates required to cool off an overheated economy. Both of these are correlated with high returns on fixed capital (someone somewhere keeps arguing that what the economy needs is higher inflation).

This means that a higher price for long term treasuries should make fixed capital less attractive — the cost of insuring against the risk in fixed capital is greater.”

It just so happens that there is Vector Auto-Regression (VAR) evidence on the relationship between QE and business investment.

This summer we showed that, in the age of zero interest rate policy (ZIRP), from December 2008 to present, the monetary base Granger causes inflation expectations, stock prices and the value of the US dollar, and that positive shocks to the monetary base (QE) lead to

statistically significant increases in inflation expectations,

statistically significant increases in stock prices,

and statistically significant decreases in the value of the US dollar.

In this series of posts we are going to show that in the Age of ZIRP, inflation expectations, stock prices and the US dollar all have an effect on investment in equipment, a component of business investment.

Private nonresidential investment in equipment is only available at a quarterly frequency. So since this analysis requires data at a monthly frequency, it is necessary to find a proxy variable for investment in equipment.

In applied macroeconomics, proxy variables typically satisfy two main requirements. First, the proxy variable should measure the equivalent characteristic of a reasonable subset of the variable being proxied. Secondly, the contemporaneous growth rates of the proxy variable and the variable being proxied should be correlated (i.e. have a relatively high Pearson’s r value).

Value of Manufacturers’ Shipments for Capital Goods: Nondefense Capital Goods Excluding Aircraft Industries (ANXAVS) overlaps in content considerably with US private nonresidential investment in equipment, and is available at a monthly frequency back to January 1992. Here is a graph of the natural log of ANXAVS and the natural log of Gross Private Domestic Investment: Fixed Investment: Nonresidential: Equipment (Y033RC1Q027SBEA) since 1992Q1.

MS Investment_1

ANXAVS overlaps in content with private nonresidential investment in equipment, and it ranges from 77.4% to 116.2% of Y033RC1Q027SBEA from 1992Q1 through 2015Q3. So it would appear that the first proxy variable requirement is well satisfied.

Now we must check to see if the two variables are correlated. Here are the results of regressing the logged difference (i.e. the growth rate) of Y033RC1Q027SBEA on the logged difference of ANXAVS and the corresponding scatterplot with the Ordinary Least Squares (OLS) regression line.

MS Investment_2

MS Investment_3

The R-squared value is approximately 0.633. Since the growth rates are positively correlated, the Pearson’s r value is +0.796, which is above average for a macroeconomic proxy variable. So it would appear that the second proxy variable requirement is well satisfied. Thus we conclude that ANXAVS is a suitable monthly frequency proxy for private nonresidential investment in equipment.

In Part 2 we’ll check to see if inflation expectations, stock prices or the value of the US dollar are “correlated” with private nonresidential investment in equipment in the age of ZIRP.

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